Sunday 18 March 2018

A tale of two banks

After a decade fighting for survival, AIB's 2017 results outshone those of great rival Bank of Ireland as the 'Big Two' continue to dominate, writes Dan White

Francesca McDonagh , CEO, Bank of Ireland. Photo: Fennell Photography
Francesca McDonagh , CEO, Bank of Ireland. Photo: Fennell Photography
Dan White

Dan White

The two big banks published their 2017 results last week. While AIB grew its profits and lending, Bank of Ireland's underlying profits and loan book both shrank last year.

It was very much a tale of two banks last week - and it was all smiles at newly-refloated AIB.

Bernard Byrne, Chief Executive of AIB. Photo: INM
Bernard Byrne, Chief Executive of AIB. Photo: INM

Operating profit before bad loan provisions were up by a further 23pc to €1.54bn. This strong increase in its underlying profitability meant that AIB was able to pile up even more capital with its common equity tier one capital ratio (the measure used by banking regulators and investors to assess a bank's financial strength) rising from 15.3pc to 17.5pc.

This jump in AIB's CET 1 has allowed it to increase its dividend to shareholders by 30pc to 12 cent a share.

Across town at Bank of Ireland, where new boss Francesca McDonagh was delivering her maiden set of results, the atmosphere was far more subdued.

While underlying profits before provisions increased by 16pc to €1.27bn, provisions against bad loans at Bank of Ireland rose from just €15m in 2016 to €178m in 2017.

When these provisions are taken into account, Bank of Ireland's underlying profit before exceptional items increased by less than 2pc to €1.1bn.

By comparison, AIB was able to write back a further €121m of previous loan loss provisions in 2017, down from a write-back of €298m.

This means that its underlying profit before exceptional items increased almost 7pc to €1.57bn last year. Despite having a considerably smaller year-end loan book than Bank of Ireland - €63.3bn vs €76bn - AIB earns a significantly higher net interest margin (the difference between the average rate it charges its borrowers and pays its depositors), 2.58pc vs 2.29pc, than its major domestic rival.

This higher net interest helps to explain AIB's ability to squeeze higher profits from a smaller loan book.

But that is only a partial explanation. As Davy analyst Stephen Lyons points out, there are significant differences between the two banks.

"AIB is largely an Irish-focused operation, whereas BoI has greater geographic diversification through its more significant presence in the UK," said Lyons.

"Purely looking at both banks' Irish franchises there wouldn't be the same disparity on profitability metrics. BoI's new CEO has clearly stated that the returns in the UK franchise need to improve and the forthcoming capital markets day will detail BoI's strategy to achieve this.

"At the end of 2017, Bank of Ireland had a UK loan book of £28bn (€31.6bn), over 40pc of its total lending. By comparison, only €9bn of AIB's lending, just 14pc of the total, was in the UK - mainly its Northern Ireland First Trust retail banking operation."

Lyons also points out that Bank of Ireland is a much less capital-intensive bank than AIB with a year-end CET 1 ratio of just 13.8pc.

This means that it holds significantly more capital for each loan than Bank of Ireland.

"Despite AIB's higher reported profitability, this doesn't flow through as favourably with respect to capital invested. AIB's headline return on equity metric is negatively impacted by its large amount of surplus capital and a higher level of required capital per loan. This will improve over time, particularly through normalising its higher level of non-performing loans", he says.

Not alone does AIB have a significantly higher net interest margin than Bank of Ireland, it also has a much lower cost/income ratio, a key measure of bank efficiency, of just 48pc in 2017 as against 62pc at Bank of Ireland.

While these two figures are not directly comparable, the AIB figure was flattered by loan book write-backs and its underlying cost/income ratio was 53pc, while over at Bank of Ireland it was artificially boosted by increased IT investment with the underlying figure being about 59pc.

However, even when one filters out these distortions, there is still a significant disparity between the two banks' cost/income ratios, of about 6pc. Cutting its cost/income ratio to the AIB level would add about €350m to the Bank of Ireland bottom line.

"AIB has just completed a three-year strategic technology programme and is therefore better able to capture efficiency gains in the near term.

"By contrast, BoI is in the middle of a much larger far-reaching technology programme.

"This will weigh near-term on earnings, but is expected to better future-proof BoI's technology position", says Davy's Lyons.

Bank of Ireland spent €195m upgrading its core banking platform in 2017. There will be further heavy spending this year, at least €100m, and similar amounts in 2019 and 2020.

While AIB concentrated on upgrading legacy IT systems, Bank of Ireland has gone for a 'big bang' approach, ripping out its legacy systems and installing new best-in-class systems.

Will the higher up-front costs of this root and branch approach deliver greater operating efficiencies for Bank of Ireland in the medium to long-term? If the example of AIB is any guide, the savings could be considerable.

AIB boss Bernard Byrne told the results announcement that his bank has taken €420m of costs out of the bank over the past three years. When unveiling the results, Byrne laid great stress on a return to "normality" at AIB.

One example of this is that as recently as three years ago AIB had €20bn of Nama senior bonds on its balance sheet.

These have now all been redeemed and replaced by more conventional sources of funding, such as customer deposits and debt securities.

This greater stress on lowering costs and upgrading IT systems does not bode well for either of the banks' branch networks.

In 2017, 95pc - that's 19 out of every 20 of AIB's customer transactions - were automated.

It was a similar story at Bank of Ireland, where the vast bulk of transactions are also conducted outside the traditional branch.

With a heavy IT investment to justify and her previous record in the UK, where as head of HSBC's retail banking operation between 2012 and 2017 she closed 40pc of its branches, will McDonagh be able to resist the temptation to follow AIB's example and take the axe to Bank of Ireland's retail branch network?

Stand by for much wailing and gnashing of teeth from politicians and community representatives in the affected locations if such an axe were to fall.

AIB and Bank of Ireland both recorded a further significant reduction in the volume of their problem loans in 2017. Impaired loans fell by almost a third from €9.1bn to €6.3bn at AIB and from €9.4bn to €6.5bn at Bank of Ireland.

While still on the high side, about a tenth of AIB's total loan book, and a twelfth of Bank of Ireland's are still impaired. AIB's problem loans are down 78pc from their peak while Bank of Ireland's are down by over two-thirds.

This continued reduction in problem loans at both of the main banks opens up at least the possibility, that after falling continuously for almost a decade, AIB and Bank of Ireland may start to grow their loan books once again in 2018.

Indeed, this return to loan growth has probably already started at AIB with earning loans (ie the gross loans figure less impaired loans and provisions) inching ahead by 2pc to €57bn last year.

Almost unnoticed amid the market disappointment at Bank of Ireland's results was the fact that it announced a resumption of dividend payments to shareholders after a gap of almost a decade. Bank of Ireland shareholders will receive a 2017 dividend of 11.5 cent per share.

While the return to dividends at Bank of Ireland came a year later than at AIB, it still marked a significant milestone in the return of the Irish banking system to financial health.

Which is more than can be said of most of the other banks operating in Ireland.

Last Friday week Ulster Bank, which is owned by state-controlled UK bank RBS, announced its 2017 results.

After recording a minuscule €37m profit in 2016, Ulster Bank plunged back into the red in 2017 with a €162m loss. The decline in Ulster's 2017 performance was primarily due to a €68m loan loss provision, a €206m turnaround on the €138m write-back booked in 2016.

Also showing renewed signs of distress is 75pc state-owned mortgage bank PTSB.

With 28pc of its loan book categorised as non-performing, it has come under renewed pressure from the ECB to sell off some of its dud loans, possibly up to €4bn worth, most likely to so-called 'vulture funds'.

The announcement of PTSB's plans to sell off some of its loans has unleashed a political firestorm, with the Government agreeing not to block Fianna Fail finance spokesman Michael McGrath's bill to extend Central Bank regulation to buyers of mortgage books. AIB's Byrne cautions that any such legislation needs to be carefully thought through.

"Whatever comes out [of legislation to regulate vulture funds] must respect the principle of secured lending. That is crucial to mortgage pricing."

While RBS decided, admittedly after much soul-searching, to stick it out in the Irish market with Ulster Bank, the latest PTSB controversy once again raises serious doubts about its ability to survive as an independent entity.

All of which means that, unless very high Irish net interest margins attract new overseas players into the Irish banking market, Irish borrowers, both households and businesses, will continue to be largely dependent on the 'Big Two' of AIB and Bank of Ireland.

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